When you make payments on a personal or business loan, you're actually paying two discrete things: loan interest, and loan principal.
Loan principal is the amount of debt you owe, while interest is what the lender charges you to borrow the money. Interest is usually a percentage of the loan's principal balance.
Either your loan amortization schedule or your monthly loan statement will show you a breakdown of your principal balance, how much of each payment will go toward principal, and how much will go toward interest.
When you make loan payments, you're making interest payments first; the the remainder goes toward the principal. The next month, the interest charge is based on the outstanding principal balance. If it's a big one (like a mortgage loan or student loans) the interest might be front-loaded so your payments are 90% interest, 10% principal, and then toward the end of the term, your payments are 10% interest and 90% principal.
To illustrate, let's say Hannah's Hand-Made Hammocks borrows $10,000 at a 6% fixed interest rate in July. Hannah will repay the loan in monthly installments of $193 over a five-year term. Here's a look at how Hannah's loan principal would go down over the first couple months of the loan.
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As you can see from the illustration, each month, the 6% interest rate applies only to the outstanding principal. As Hannah continues making payments and paying down the original loan amount, more of the payment goes toward principal each month. The lower your principal balance, the less interest you'll be charged.
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A common mistake when accounting for loans is to record the entire monthly payment as an expense, rather than booking the initial loan as a liability and then booking the subsequent payments as:
To illustrate, let's return to Hannah's $10,000 loan. When Hannah takes out the loan and receives the cash, the entry on her books would be as follows:
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Hannah's first loan payment in August should be recorded as follows:
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The $143 reduces the liability for the loan on Hannah's Hand-Made Hammocks's balance sheet, the $50 will be an expense on its Profit and Loss Statement, and the credit to cash reflects the payment coming out of Hannah's Hand-Made Hammocks's checking account.
If Hannah booked the original amount as a liability, but then booked each $193 monthly payment as an expense of the life of the loan, at the end of each year, Hannah's liabilities would be overstated on its balance sheet, and its expenses would be overstated on its Profit and Loss Statement. If the error isn't corrected before Hannah prepares her business tax return, the company might underpay the tax it owes for that year. If her bank wanted to see financial statements before approving another loan application or renewing a line of credit, the overstated liability might negatively impact the bank's decision.
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If you're getting depressed thinking about how much interest you're actually paying, there's good news: Most lenders let you make additional principal payments to pay off a loan faster. Making extra principal payments will reduce the amount of interest you'll pay over the life of a loan since interest is calculated on the outstanding loan balance.
For example, if Hannah pays an additional $100 toward the loan's principal with each monthly payment, she will reduce the amount of interest she pays over the life of the loan by $609 and shorten the five-year loan term by almost two years.
If you want to pay your loan off early, talk to your lender, credit card provider, or loan servicer to find out how the lender applies extra payments. Some lenders automatically apply any extra payments to interest first, rather than applying them to the principal. Other lenders may charge a penalty for paying off the loan early, so call your lender to ask how you can make a principal-only payment before making extra payments.
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